Saturday, August 08, 2009

Not Getting it Right on Addressing Financial Failure

Several reforms are needed to reduce or eliminate the cost of financial failure to the taxpayers. Reform should start by increasing a banker’s responsibility for losses. The administration’s proposal does the opposite by making the Federal Reserve responsible for systemic risk.

The administration’s proposal sacrifices much of the remaining independence of the Federal Reserve. Congress, the administration, and failing banks or firms will want to influence decisions about what is to be bailed out. I believe that is a mistake.

If we use our capital to avoid failures instead of promoting growth we sacrifice a socially valuable arrangement—central bank independence. We encourage excessive risk-taking and moral hazard.

I believe there are better alternatives than the administration’s proposal.

First step: End TBTF [Too Big to Fail]. Require all financial institutions to increase capital more than in proportion to their increase in size of assets. TBTF is perverse. It allows banks to profit in good times and shifts the losses to the taxpayers when crises or failures occur.

Recognize that regulation is an ineffective way to change behavior. My first rule of regulation states that lawyers regulate but markets circumvent burdensome regulation.